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Commentary
“I can't change the direction of the wind, but I can adjust my sails to always reach my destination.”
– Jimmy Dean
Have shifting winds blown away the inversion?
It was bound to happen at some point: the shift to a positively sloped yield curve. This past month saw the power of global economics supersede the policy of any one central bank. Rates around the world appear to be on an upward march. The poster child of the asset side of the “carry trade,” the Bank of New Zealand, raised short-term rates to 8.00%. Ten-year German bunds have pierced through 4.50%, the highest level in almost five years. Even Japanese bond yields, which have stood at levels below one percent for a protracted period, are beginning to increase. Given the dramatic re-pricing of the yield curve, it’s not surprising that volatility levels on Treasury rates have increased significantly.
Back in the U.S., the moribund housing market appears to be but one-of-20, as opposed to one-of-three legs of a stool. That’s in spite of Chairman Bernancke’s prepared comment last week that housing “appears likely to remain a drag on economic growth for somewhat longer than previously expected.” In reality, the decline in housing sales and construction activity has shaved approximately a full percentage point off of GDP growth over the past several quarters. News of trailing housing prices has been overshadowed by continued strength in the payroll picture. During the month of May, non-farm payroll increased by a healthy 157,000. In spite of spiraling energy costs, consumers seem to remain confident. During the first quarter, consumer spending rose at an annualized clip of 3.8%.
For now, that vindicates the Fed’s longstanding wait-and-see approach. The implied forward yield curve appears to back the scenario of continued unchanged short-term rates, albeit with a slight bias to a rate increase one year away. That’s a bit of a reversal from last month’s implied forward curve, which had built in an ease of 25 basis points, one year out.
Still there’s trouble brewing in the longer end of the yield curve. Last week, 30-year Treasuries saw occasional intra-day losses of more than two points. Ten-year Treasuries are now comfortably above 5.00%, and presently exceed the two-year sector by approximately 14 basis points. Inflationary signs appear to be gaining momentum: first-quarter unit labor costs rose by an unexpected annualized rate of 1.8%. Costs were anticipated to have risen by less than one-third of that amount. The culprits: rising compensation and reduced output-per-hour. That’s not a particularly good harbinger for increased productivity.
So, what might cause a reversal in today’s higher rates, stronger economic growth, and whiff of inflation? Clearly, weaker payroll growth. Also, in spite of the fact that housing and related mortgage activities are among the least robust contributors to the current economy, most mortgage activity is now concentrated in the 30-year sector. Might higher fixed-rate mortgages put a damper on the wave of variable-rate mortgages that are due to re-set later in the year and further crimp debt serviceability?
Incidentally, one argument making the rounds on the subject of sub-prime fallout would serve to diminish the volume of potential foreclosures emanating from payment shock. Consider the case of a subprime borrower who took a “2/28” mortgage two years ago, who is now faced with the prospect of re-financing an increased variable rate into a fixed rate. By the very act of having promptly paid 24 months of principal and interest, there is a good chance that such a borrower would now be categorized as a “prime” borrower and refinance into the conventional 30-year market.
The housing barometers continue to be soft. The National Association of Realtors Index of Pending Sales is now at its lowest level in over four years. The amount of unsold homes on the market is also the largest that it has been since that association started keeping records in 1999. Higher fixed-rate mortgage rates will certainly not support a turnaround.
The net export picture is providing a nice offset to housing’s drag on GDP. Indeed, April exports contributed to a 6.2% reduction in the U.S. trade gap. A continuation of this trend could contribute in excess of 0.5% in incremental growth to second-quarter GDP.
Alan Greenspan often commented on the “conundrum” of long-term rates seldom correlating with short-term rates and associated central bank monetary policy. Throughout the final years of his term, he ascribed the phenomenon of low long-term rates as a product of excessive global savings. That is, the savings glut was being placed in U.S. fixed-income securities. The key question we must now ponder concerns whether or not these global savings are being redirected to other markets, including those markets that are exhibiting higher levels of economic growth relative to the U.S. If this is the case and long-term rates further exacerbate the housing market, it wouldn’t be beyond the realm of possibility to see the Fed ease monetary policy—further normalizing the positive slope of the yield curve—provided inflation becomes comfortably below the Fed’s articulated goal of 2.0%. For now, the forward markets see a flat funds rate of 5.25%, at least over the next 12 months.
John P. Biestman, CFA, is Director of Business Development at the Federal Home Loan Bank of Seattle.
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